Diversifying your stock portfolio by investing in a collection of stocks might be an effective way of reducing the risks associated with investing in stocks.
So before we dive further into this discussion about using diversification as a tool to manage your portfolio risk, let us try and understand first what ‘risk’ actually is.
Risk is the probability that an outcome of an event would be not as per plan.
We invest in stocks with the view of making money by riding the growth in the price of stocks over time.
The risk here is that an investment decision we take, might not give us the desired results and we could end up losing money in the process.
Why is there a risk associated with investing in stocks?
When we make an investment in a stock, we make assumptions about the growth in revenues and profitability of the company in the future. Most of these assumptions are based on current facts.
If we have reasons to believe in the growth story of a company, we go ahead and make an investment in it.
However, we all know, that it is almost impossible to predict the future with an absolute certainty.
Future events might not turn out to be as anticipated. For example, as we have seen in the case of the Indian Telecom Industry, the rise of a strong competitor can disrupt the industry, and have a massive negative impact of the growth and profitability of the existing players.
With the increased absorption of technology, we may see many more disruptions in the near future.
Diversification acts as a cushion against risk!
Diversifying your portfolio by investing in a collection of stocks helps reduce your portfolio risk.
This is because even if a couple of your investment decisions go wrong, the rise in the price of other stocks you hold, would make up for any losses you incur and help preserve your capital invested.
How to achieve diversification in your stock portfolio?
We have already discussed that investing in a basket of stocks might help us reduce portfolio risk. But then, how do we decide on what and how many stocks to invest in?
The pointers below might help.
- It is important to diversify only into a limited number of stocks that you can reasonably track. Over diversify, and you risk losing track of the stocks you own in the process. Keeping an active track of the stocks you own is important. This would help you detect any distress signals in the companies you own early – so that you can exit a stock in time and in doing, so contain your losses.
- Diversification does not mean that you can pick up any stock that you like. Always invest into companies that have strong fundamentals and a reasonably strong potential of growth going forward. Diversification does not absolve you from doing your duty of reasonable research before investing in a stock.
- Also, make sure that you diversify into different industries as well. This is because if your portfolio has a large concentration of stocks pertaining to a particular industry any industry disruption or obsolescence would significantly impact the value of your investments. However, make sure that you understand an industry well before investing.
- Low cost equity index funds – that invest in the constituent stocks of an index, can also help you achieve portfolio diversification.
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